Question 1

If Alan is risk-averse, then he will always
A) choose not to play a game where he has a 50 percent chance of winning $5 and a 50 percent chance of losing $5.
B) choose not to play a game where he has a 75 percent chance of winning $5 and a 25 percent chance of losing $5.
C) choose to play a game where he has a 55 percent chance of winning $5 and a 45 percent chance of losing $5.
D) All of the above are correct.

Accepted Answer

If Alan is risk-averse, he will be more concerned about minimizing his losses than maximizing his gains. Therefore, he will choose not to play a game where there is a 50 percent chance of losing $5, even if there is a 50 percent chance of winning $5. He will opt for choices where the probability of losing is low, even if the probability of winning is less.

Question 2

Which of the following games might a risk-averse person play?
A) a game where she has a 70 percent chance of winning $1 and a 30 percent chance of losing $1
B) a game where she has a 60 percent chance of winning $100 and a 40 percent chance of losing $100
C) a game where she has a 60 percent chance of winning $2 and a 40 percent chance of losing $1
D) All of the above are correct.

Accepted Answer

The answer of Which of the following games might a...

Question 3

A measure of the volatility of a variable is its
A) present value.
B) future value.
C) return.
D) standard deviation.

Accepted Answer

Standard deviation is a statistical measure of the dispersion or variability of a set of data. In finance, it is often used as a measure of the volatility of a variable, such as stock prices or investment returns. A higher standard deviation indicates a greater degree of volatility or risk.

Question 4

If a person is risk averse, then as wealth increases, total utility of wealth
A) increases at an increasing rate.
B) increases at a decreasing rate.
C) decreases at an increasing rate.
D) decreases at a decreasing rate.

Accepted Answer

Risk-averse individuals are less willing to take risks and as their wealth increases, the marginal utility of wealth decreases. Therefore, the total utility of wealth increases at a decreasing rate.

Question 5

Recently, Lisa's wealth increased by $500. If her wealth were to increase by another $500 in the near future, then her utility would increase, but not by as much as it increased with the recent increase to her wealth. Based on this information, Lisa's utility function
A) and marginal utility function are both upward sloping.
B) and marginal utility function are both downward sloping.
C) is upward sloping and her marginal utility function is downward sloping.
D) is downward sloping and her marginal utility function is upward sloping.

Accepted Answer

This scenario reflects the principle of diminishing marginal utility, which states that as an individual consumes more of a good or service, the marginal utility (additional satisfaction) they receive from each additional unit decreases. Lisa's utility function must be upward sloping to reflect the fact that she gains more utility as her wealth increases. However, her marginal utility function must be downward sloping to reflect the fact that the additional utility she gains from each additional $500 of wealth decreases.

Question 6

Given that Tamar is a risk-averse person, she might accept a bet with a 50 percent chance of losing $100 today if she had a 50 percent
A) chance of winning $120 in two years and the interest rate was 11%.
B) chance of winning $114 in two years and the interest rate was 7%.
C) chance of winning $110 in two years and the interest rate was 3%.
D) None of the above are correct; a risk averse person would not accept any of the above bets.

Accepted Answer

A risk-averse person would require a higher expected return to compensate for the risk of losing $100 today. Option C offers the highest expected return at 2.954%, compared to option A with an expected return of 2.848% and option B with an expected return of 2.669%. Therefore, Tamar might accept the bet with a 50 percent chance of winning $110 in two years with an interest rate of 3%.

Question 7

If a person is risk averse, then she has
A) diminishing marginal utility of wealth, implying that her utility function gets flatter as wealth increases.
B) diminishing marginal utility of wealth, implying that her utility function gets steeper as wealth increases.
C) increasing marginal utility of wealth, implying that her utility function gets flatter as wealth increases.
D) increasing marginal utility of wealth, implying that her utility function gets steeper as wealth increases.

Accepted Answer

A risk-averse individual has a diminishing marginal utility of wealth, meaning that the more wealth they have, the less additional utility they receive from each additional unit of wealth. As a result, their utility function gets flatter as wealth increases, and they are more willing to take actions that minimize their risk and preserve their current level of wealth.

Question 8

A risk-averse person has
A) utility and marginal utility curves that slope upward.
B) utility and marginal utility curves that slope downward.
C) a utility curve that slopes down and a marginal utility curve that slopes upward.
D) a utility curve that slopes upward and a marginal utility curve that slopes downward.

Accepted Answer

A risk-averse person is typically willing to pay a premium to avoid risk. Therefore, their utility curve will slope upward as they gain increasing utility from higher levels of wealth. However, as they accumulate more wealth, the marginal utility gained from each additional unit of wealth decreases, causing their marginal utility curve to slope downward.

Question 9

Which of the following games might a risk-averse person play?
A) a game where she has a 50 percent chance of winning $1 and a 50 percent chance of losing $1
B) a game where she has a 50 percent chance of winning $100 and a 50 percent chance of losing $100
C) a game where she has a 60 percent chance of winning $1 and a 40 percent chance of losing $1
D) a game where she has a 40 percent chance of winning $1 and a 60 percent chance of losing $1

Accepted Answer

A risk-averse person would prefer a game with a higher chance of winning and a lower chance of losing. Game C has a 60 percent chance of winning $1 and only a 40 percent chance of losing $1, which makes it the best choice for a risk-averse person.

Question 10

Which of the following is correct concerning a risk-averse person?
A) She would not play games where the probability of winning and losing a dollar are the same.
B) She might not buy health insurance if she thinks her risks are low.
C) Her marginal utility of wealth decreases as her income increases.
D) All of the above are correct.

Accepted Answer

A) Risk-averse individuals avoid situations where the odds are even and they might lose money.
B) Risk-averse individuals might decide not to purchase insurance if they think their likelihood of needing it is low.
C) The marginal utility of wealth decreases as income increases for risk-averse individuals. This means that the more money they have, the less satisfaction they get from each additional dollar they receive.

Question 11

Svetlana is risk averse. Which of the following is correct about Svetlana?
A) Her marginal utility of wealth increases as her income increases.
B) She will always accept a bet if the probability of winning a dollar is the same as the probability of losing a dollar.
C) Her utility function is a straight line.
D) None of the above are correct.

Accepted Answer

The answer of Svetlana is risk averse. Which of the...

Question 12

A risk-averse person
A) has a utility curve where the slope increases with wealth, and might take a bet with a 80 percent chance of winning $300 and a 20 per chance of losing $300.
B) has a utility curve where the slope increases with wealth, and would never take a bet with a 80 percent chance of winning $300 and a 20 per cent chance of losing $300.
C) has a utility curve where the slope decreases with wealth, and might take a bet with a 80 percent chance of winning $300 and a 20 per chance of losing $300.
D) has a utility curve where the slope decreases with wealth, and would never take a bet with a 80 percent chance of winning $300 and a 20 per cent chance of losing $300.

Accepted Answer

The answer of A risk-averse person
A) has a utility curve...

Question 13

Diminishing marginal utility of wealth implies that the utility function is
A) upward-sloping and has decreasing slope.
B) upward-sloping and has increasing slope.
C) downward-sloping and has decreasing slope.
D) downward-sloping and has increasing slope.

Accepted Answer

The answer of Diminishing marginal utility of wealth implies that...

Question 14

The largest reduction in a portfolio's risk is achieved when the number of stocks in the portfolio is increased from
A) 80 to 100.
B) 40 to 80.
C) 10 to 20.
D) 1 to 10.

Accepted Answer

The largest reduction in a portfolio's risk occurs when the number of stocks is increased from 1 to 10, due to the significant benefits of diversification at this early stage. Beyond this point, the marginal benefit of adding more stocks diminishes.

Question 15

Diversification of a portfolio
A) can eliminate market risk, but it cannot eliminate firm-specific risk.
B) can eliminate firm-specific risk, but it cannot eliminate market risk.
C) increases the portfolio's standard deviation.
D) is not necessary for a person who is risk averse.

Accepted Answer

Diversification of a portfolio cannot eliminate market risk, but it can reduce it by spreading the investment across different asset classes, sectors, and regions. However, it can eliminate firm-specific risk by investing in a large number of companies in different industries and geographies. This ensures that the impact of adverse events affecting any one company or industry is minimized on the overall portfolio. Diversification does not necessarily increase the standard deviation of the portfolio, but it can help manage the risk-return tradeoff. Diversification is important for all investors, regardless of their risk aversion, to manage their investment risk.

Question 16

As the number of stocks in a person's portfolio increases,
A) the risk of the portfolio increases, as indicated by the increasing value of the standard deviation of the portfolio.
B) the risk of the portfolio increases, as indicated by the decreasing value of the standard deviation of the portfolio.
C) the risk of the portfolio decreases, as indicated by the increasing value of the standard deviation of the portfolio.
D) the risk of the portfolio decreases, as indicated by the decreasing value of the standard deviation of the portfolio.

Accepted Answer

Having a diversified portfolio is a way to reduce risk, as it spreads the risk among different investments. The standard deviation of a portfolio measures the variability of returns from the average return of the portfolio. When the number of stocks in the portfolio increases, the diversification increases, and the risk of the portfolio decreases, as indicated by the decreasing value of the standard deviation. Therefore, the best answer is D.

Question 17

Risk
A) can be reduced by placing a large number of small bets rather than a small number of large bets.
B) can be reduced by increasing the number of stocks in a portfolio.
C) Both A and B are correct.
D) Neither A nor B are correct.

Accepted Answer

Both A and B are correct strategies for reducing risk. By placing a large number of small bets, an individual can diversify their investments and avoid putting all their money into one risky asset. Similarly, by increasing the number of stocks in a portfolio, an individual can spread their risk across multiple companies and industries. These strategies can help to reduce the impact of any single investment failing or underperforming.

Question 18

Mary Beth is risk averse and has $1,000 with which to make a financial investment. She has three options. Option A is a risk-free government bond that pays 5 percent interest each year for two years. Option B is a low-risk stock that analysts expect to be worth about $1,102.50 in two years. Option C is a high-risk stock that is expected to be worth about $1,200 in four years. Mary Beth should choose
A) option A.
B) option B.
C) option C.
D) either A or B because they are the same to her.

Accepted Answer

Mary Beth is risk averse, meaning she prefers a known outcome with lower returns over a riskier option with potentially higher returns. Option A is a risk-free government bond that guarantees a 5 percent interest rate for two years, providing a known outcome. Option B is a low-risk stock that may be worth $1,102.50 in two years, but there is no guarantee. Option C is a high-risk stock that is expected to be worth about $1,200 in four years, but Mary Beth may not be willing to wait that long or take on the higher risk. Therefore, Option A is the best choice for Mary Beth as it provides a known outcome with a guaranteed return.

Question 19

The utility function of a risk-averse person has a
A) positive slope and gets steeper as wealth increases.
B) positive slope but gets flatter as wealth increases.
C) negative slope but gets steeper as wealth increases.
D) negative slope and gets flatter as wealth increases.

Accepted Answer

The answer of The utility function of a risk-averse person...

Question 20

The last $2,000 of Rolanda's wealth adds less to her utility than the previous $2,000. Based on this information, Rolanda has
A) increasing marginal utility of wealth and is risk averse.
B) increasing marginal utility of wealth and is not risk averse.
C) decreasing marginal utility of wealth and is risk averse.
D) decreasing marginal utility of wealth and is not risk averse.

Accepted Answer

The fact that the last $2,000 of wealth adds less to Rolanda's utility than the previous $2,000 indicates that she is experiencing decreasing marginal utility of wealth. This suggests that she is risk averse, meaning that she would be willing to pay a premium to avoid uncertain outcomes that might reduce her wealth further.

Quiz 27: The Basic Tools of Finance

If Alan is risk-averse, then he will always

Which of the following games might a risk-averse person play?

A measure of the volatility of a variable is its

If a person is risk averse, then as wealth increases, total utility of wealth

Recently, Lisa's wealth increased by $500. If her wealth were to increase by another $500 in the near future, then her utility would increase, but not by as much as it increased with the recent increase to her wealth. Based on this information, Lisa's utility function

Given that Tamar is a risk-averse person, she might accept a bet with a 50 percent chance of losing $100 today if she had a 50 percent

If a person is risk averse, then she has

A risk-averse person has

Which of the following games might a risk-averse person play?

Which of the following is correct concerning a risk-averse person?

Svetlana is risk averse. Which of the following is correct about Svetlana?

A risk-averse person

Diminishing marginal utility of wealth implies that the utility function is

The largest reduction in a portfolio's risk is achieved when the number of stocks in the portfolio is increased from

Diversification of a portfolio

As the number of stocks in a person's portfolio increases,

Risk

The utility function of a risk-averse person has a

The last $2,000 of Rolanda's wealth adds less to her utility than the previous $2,000. Based on this information, Rolanda has